Best of the Week
Most Popular
1. Investing in a Bubble Mania Stock Market Trending Towards Financial Crisis 2.0 CRASH! - 9th Sep 21
2.Tech Stocks Bubble Valuations 2000 vs 2021 - 25th Sep 21
3.Stock Market FOMO Going into Crash Season - 8th Oct 21
4.Stock Market FOMO Hits September Brick Wall - Evergrande China's Lehman's Moment - 22nd Sep 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
7.AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
8.Why Silver Price Could Crash by 20%! - 5th Oct 21
9.Powell: Inflation Might Not Be Transitory, After All - 3rd Oct 21
10.Global Stock Markets Topped 60 Days Before the US Stocks Peaked - 23rd Sep 21
Last 7 days
VR and Gaming Becomes the Metaverse - 7th Dec 21
How to Read Your Smart Meter - Economy 7, Day and Night Rate Readings SMETS2 EDF - 7th Dec 21
For Profit or for Loss: 4 Tips for Selling ASX Shares - 7th Dec 21
INTEL Bargain Teck Stocks Trading at 15.5% Discount Sale - 7th Dec 21
US Bonds Yield Curve is not currently an inflationist’s friend - 7th Dec 21
Omicron COVID Variant-Possible Strong Stock Market INDU & TRAN Rally - 7th Dec 21
The New Tech That Could Take Tesla To $2 Trillion - 7th Dec 21
S&P 500 – Is a 5% Correction Enough? - 6th Dec 21
Global Stock Markets It’s Do-Or-Die Time - 6th Dec 21
Hawks Triumph, Doves Lose, Gold Bulls Cry! - 6th Dec 21
How Stock Investors Can Cash in on President Biden’s new Climate Plan - 6th Dec 21
The Lithium Tech That Could Send The EV Boom Into Overdrive - 6th Dec 21
How Stagflation Effects Stocks - 5th Dec 21
Bitcoin FLASH CRASH! Cryptos Blood Bath as Exchanges Run Stops, An Early Christmas Present for Some? - 5th Dec 21
TESCO Pre Omicron Panic Christmas Decorations Festive Shop 2021 - 5th Dec 21
Dow Stock Market Trend Forecast Into Mid 2022 - 4th Dec 21
INVESTING LESSON - Give your Portfolio Some Breathing Space - 4th Dec 21
Don’t Get Yourself Into a Bull Trap With Gold - 4th Dec 21
GOLD HAS LOTS OF POTENTIAL DOWNSIDE - 4th Dec 21
4 Tips To Help You Take Better Care Of Your Personal Finances- 4th Dec 21
What Is A Golden Cross Pattern In Trading? - 4th Dec 21
Bitcoin Price TRIGGER for Accumulating Into Alt Coins for 2022 Price Explosion - Part 2 - 3rd Dec 21
Stock Market Major Turning Point Taking Place - 3rd Dec 21
The Masters of the Universe and Gold - 3rd Dec 21
This simple Stock Market mindset shift could help you make millions - 3rd Dec 21
Will the Glasgow Summit (COP26) Affect Energy Prices? - 3rd Dec 21
Peloton 35% CRASH a Lesson of What Happens When One Over Pays for a Loss Making Growth Stock - 1st Dec 21
Stock Market Sentiment Speaks: I Fear For Retirees For The Next 20 Years - 1st Dec 21 t
Will the Anointed Finanical Experts Get It Wrong Again? - 1st Dec 21
Main Differences Between the UK and Canadian Gaming Markets - 1st Dec 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Can the "Mimetic Effect" Explain Speculative Bubbles?

Stock-Markets / Liquidity Bubble Jun 25, 2009 - 08:23 AM GMT

By: MISES

Stock-Markets

Best Financial Markets Analysis ArticleJeremie T.A. Rostan writes: For the enemies of freedom in general , and of the economy in particular, the recent crash has been the occasion to re-assert that markets in general, and financial ones in particular, are inherently unstable — and thus dangerous — because they are driven by irrational behaviors such as the "mimetic effect," which, according to many experts and politicians, explains how Wall Street booms and then busts.


The idea, put a little simplistically, is this: when one investor speculates on the rise of a financial asset, he bids up its price, thus enticing more investors to speculate on its rise; they, in their turn, bid up its price, thus inflating a frantic speculative bubble that totally disconnects the market value of the financial asset from the real value of the underlying real asset.

This notion of speculation as a (temporary) "self-fulfilling prophecy" does not withstand even a thirty-second rational examination.

First, it does not even meet the formal requirements of a logical explanation.

Indeed, if the "mimetic effect" were true, every buying of a financial asset by an investor should lead to an exuberant rise in its price. This theory offers no criterion explaining why some speculations lead to bubbles and why others do not.

Second, if the instigator of the mimetic speculation initiates a bad speculation, he should be losing money. The problem, in fact, is not so much the "mimetic effect" in and of itself. Carl Menger, for instance, explained how money was established thanks to imitative behavior in which market participants follow the path opened by successful pioneers.

Three Problems

There are 3 problems to address in accounting for any speculative bubble:

  1. There is a lag in time between the bad speculation and the financial losses that reveal it. The "mimetic effect" does not account for this.
  2. If the prices of certain financial assets are to be greatly inflated, it must be because investors anticipate great profits. Now, what, except a sudden and collective mania, explains such exuberance?
  3. How is a speculative bubble fed? Where do investors get the limitless means they waste in irrational ventures?

In order to solve these three problems and get a rational explanation of the formation of speculative bubbles in financial markets, let's examine two cases.

First Case: The Misallocation of Capital

In this first case, we consider investors as financial intermediaries with capital limited to actual savings. In this scenario, it is not only plausible but even necessary that some investors make bad investments, thus misallocating capital to low- and even negative-return assets.

This answers problem 2: because of uncertainty, speculation will happen to be deceptive. However, under such conditions, individual imperfect information concerning the future state of the economy is the only reason for false expectation.

Speculating on an asset and buying some of it, an investor can entice fellow market participants to join in his fate. However, the supply of capital being limited to net savings, from one period to another, the supply of funds which can be misallocated is strictly limited; and, since the return on investment will increase in the assets from which they are taken, the simple pursuit of profit will both reveal and correct the malinvestment.

Second Case: Credit Expansion

What happens when financial intermediaries have access to actual savings and newly created credit funds?

As explained by the Austrian business-cycle theory, newly created funds imply a decrease in interest rates. This decrease will have various effects on various financial assets, and thus on their relative prices.

Generally speaking, all future goods appear cheaper, and more profitable, than they really are — considering the real interest rate. But they appear even more so according to parameters such as the position of their underlying real assets in the structure of production, the period of production of their products, their durability, or the risk entailed in their offering.

As a consequence, we have here a reason for a collective error, since the manipulation of interest rates makes it appear more profitable to all investors to invest in certain assets.

And we also have an answer to the question concerning the origin of the flow of funds invested in these particularly interest-rate-sensitive and risky financial assets: the newly created credit.

Finally, the hypothesis of a monetary expansion also explains the time lag between the bad speculation on those assets and the losses they imply. Because of the injection of new liquidities in the economy, the structure of prices is loosened and, just like the structure of production, becomes distended. Misallocated funds do not have to be taken from other assets, and their overinvestment in sensitive and risky assets can go on up to the point to which their illusory rise in profitability is superior to that of less interest-rate-sensitive and risky investments.

Thus, speculative error can go on at no cost as long as that limit is not reached.

In fact, there are two other limits. First, the rate of interest tends to rise to its real value, undermining the pseudoprofitability of the real assets underlying sensitive and risky assets. Thus, new credit has to be created constantly.

Second, the injection of liquidity will have to be stopped at some point, or else hyperinflation will take place.

Conclusion

The "mimetic-effect" explanation of speculative bubbles fails to distinguish between two radically different cases: on the one hand, the misallocation of a limited supply of savings by financial-market participants; on the other hand, the investment of a supply of funds superior to actual savings, i.e., of artificial credit created by a deceptively low rate of interest.

Only the latter can lead to speculative bubbles.

A good explanation of a phenomenon, such as the formation of speculative bubbles on financial markets, demonstrates itself in that it also explains bad explanations: verum index sui et falsi.

What then is the so-called "mimetic effect," really? When new liquidities are injected in a financial system, asset prices vary. They do so differently, according to various parameters, and only step by step. The "mimetic effect" does not reveal the intrinsic irrationality of speculation: it is nothing but the process by which artificial credit is being channeled, through a distorted price structure, to interest-rate-sensitive and risky assets.

If there is a mimetic behavior, it is the one of central bankers who constantly inflate the money supply in order to re-inflate bubbles and "stabilize" financial markets.

Jérémie T.A. Rostan is "agrege de philosophie." He teaches philosophy in San Francisco, California. He wrote a study guide to Carl Menger's Principles of Economics, prepared in 2008 for distribution through Mises.org. Send him mail. See his article archives. Comment on the blog.

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in